The Nature of the Effect of the Removal of Price Controls

The nature of the hyperinflation in Russia in the 1990's is widely misunderstood. It was
not due to any shock therapy; it was due to the expansion of the money supply by the central
bank of Russia. The removal of price controls would have resulted only in a one-time ostensible
price increase, but even this is dependent upon an erroneous notion of what constitutes a
price. When price controls hold prices down below their market
equilibrium rate they create a shortage at the control level of prices and a black market.
People cannot buy as much as they would like at the control prices and often it is only a lucky
few with inside connections who get to buy at the control prices. Those without those connections
and those who want more than they get at the control price must go to the black market and pay
the higher price. The real market and the real market price is the black market price. Suppose
gasoline is rationed and the ration price set at $2 per gallon but the black market price is
$5 per gallon. Someone who buys gasoline at $2 per gallon decides whether to use that gallon
or sell it on the black market based upon the black market price of $5 per gallon not the
purchase price of $2 per gallon. The real price therefore even for those who buy at the
control price is the black market price.

The black market price is not only higher than the control price, it is higher than the
equilibrium price. Therefore when price controls are removed the real price goes down not up.
The real price goes from the black market price down to the market equilibrium price. The control
price is irrelevant but it is the price that would be used in price indices for measuring inflation.
So the effect of the removal of price controls is not real inflation but the change from a
bogus price to a real market price. However, without the continual expansion of the money supply
there would be no further price increase.

Monetary Policy in Russia in the 1990's

Viktor Gerashchenko

The head of the Central Bank of Russia was Viktor Gerashchenko. He was a dedicated
Communist and, as such, not at all interested in having the Russian economy make a smooth
transition from the Stalinist system to some version of a private market economy. Most of the
State Enterprises of the Soviet Union operated at a deficit; i.e., the ruble value of their
products was less than the ruble costs of the labor and raw materials that went into producing
them. Under the old system the state covered the difference. During the transition the government
of Russia stopped covering those deficits. The enterprises were then faced with a choice of
cutting costs, shutting down or finding some other way to cover the deficit. The only feasible
way to cover their costs was to get loans from the Central Bank. The financial system in
Russia was complicated and enigmatic but in a simpler system the effects of those loans
would have worked as follows. The loans were in the form of accounts granted at the
central bank. In a fractional reserve banking system accounts at the central bank are
high powered money. The total money supply expands by a multiple of the amount of those
central bank accounts granted. When the money supply expands in excess of the real growth of the
economy there is an increase in the price level -- inflation. In the case of Russia at the
time there was no real growth in the economy, it was in fact contracting. If the money supply
expands 5 percent and production is contracting 20 percent this is an expansion of the
money supply by about 25 percent per unit of output and there would be correspondingly high
impact on the price level. When inflation develops the velocity of money increases and thus
the impact on the rate of inflation is due to the sum of the rate of growth of the money supply and the
rate of increase of the velocity of money. Thus prices are hit by a triple whammy of expanding
money supply, decreasing output and increasing money velocity. This is how inflation rates
can be driven to astronomical levels. For more on this see the
dynamics of inflation and episodes of hyperinflation.

Tatyana Paramonova

As the price level went up the state enterprises had to go to Viktor Gerashchenko and the
Central Bank for bigger and bigger loans so the rate of inflation escalated, reaching a
level of about 5000 percent per year. Finally Viktor Gerashchenko was fired as head of the
Central Bank of Russia in 1994 and his replacement was able to bring the inflation rate down
to about 10 percent per month.

In 1998 after the Russian default on its debt Boris Yeltsin
in some complicated political arrangement reappointed Gerashchenko as head of the Central
Bank. This time he was not the disaster that he was in the early 1990's. Perhap he was
chastened by Jeffrey Sachs' depiction of him as the "Worst Central Banker in the world."
Gerashchenko continued to head the Central Bank until 2002 when he retired from the Bank
but went into politics and was elected to the Duma.

Below are the rates of inflation provided by the International Monetary Fund (IMF) on
inflation in Russia from 1993 to 2004. The IMF was not able to provide that statistics
on the more severe inflation that preceded 1993.

Annual Rates of Inflation (%/yr)
in Russia, 1993-2004

Year

Inflation in ProducerPrices(%/yr)

Inflation in
ConsumerPrices(%/yr)

Inflation in the WageLevel(%/yr)

1993

943.76

874.62

822.1

1994

337.00

307.38

255.9

1995

236.46

197.41

142.2

1996

51.21

47.57

64.8

1997

14.67

14.62

23.7

1998

7.03

NA

15.3

1999

58.95

85.65

54.7

2000

46.53

20.77

52.5

2001

19.17

21.50

43.3

2002

10.43

15.72

27.3

2003

16.38

13.66

26.1

2004

23.35

10.89

22.5

The IMF gives the rates of inflation in consumer prices from 1993 to 1997. From this
a price level for each year can be computed.

The Money Supply and the Price Level in Russia, 1993-1998

Consumer PriceLevel

(millions of rubles)

Year

(1993=100)

MoneySupply

Quasi-Money

1993

100.0

23,881

17,102

1994

974.62

68,544

61,187

1995

3970.41

151,627

124,514

1996

11808.39

192,402

164,922

1997

17425.64

270,602

192,246

1998

19973.27

344,113

289,514

For 1998 and the years thereafter the IMF gives an index of consumer prices.

The Money Supply and the Price Level in Russia, 1998-2004

(millions of rubles)

Year

Consumer PriceLevel (2000=100)

MoneySupply

Quasi-Money

1998

44.6

344,113

289,514

1999

82.8

527,627

465,574

2000

100.0

880,524

688,460

2001

121.5

1,193,395

944,816

2002

140.6

1,498,463

1,361,524

2003

159.8

2,181,933

1.780,151

2004

177.2

2,848,345

2,450,354

The Quantity Theory of Money explains the increase in prices as being not only due to
there being more money in circulation but that it is being spent faster. The income
velocity of money is defined as the Gross Domestic Product (GDP) divided by the money
in circulation. The velocity of money in Russia for the period 1993 to 2004 are given
below. In this case the period was one of the moderation of inflation and there
is a downward trend in the velocity of money after 1996.

Year

GDP(billions rubles/yr)

Money+Quasi-Money(billions rubles)

Money Velocity(times per year)

1993

172

41.0

4.20

1994

611

129.7

4.71

1995

1585

275.8

5.75

1996

2200

357.3

6.16

1997

2602

462.8

5.62

1998

2630

633.6

5.68

1999

4823

993.2

4.86

2000

7306

1569.0

4.66

2001

8944

2138.2

4.18

2002

10818

2860.0

3.78

2003

13201

3962

3.33

2004

16779

5299

3.17

Conclusions

The hyperinflation in Russia in the 1990's followed the standard senario. The money
supply was increased excessively leading to inflation. The velocity of money increased
adding to the impact of the increased money supply on prices. The vicious circle continued
until Viktor Gerashchenko was replaced as head of the Central Bank. The blame for the
social devastation which resulted from the hyperinflation such as the impoverishment of the
pensioners and the destruction of the value of lifetime savings lies with the monetary
policies of Viktor Gerashchenko. When Gerashchenko was replaced by Tatyana Paramonova the
hyperinflation quickly disappeared although significant inflation continued.